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Sunday, August 3, 2008

It's All In The Notes: Leases

Consider two companies operating in the same industry. You've looked up the financial statements of each, and found they both have $1000 in assets and $100 in net income. So each has a return on assets of 10% right? Unfortunately, we don't have the whole story.

You see GAAP does not require that companies place operating leases on their balance sheets, even if they may not be canceled! In effect, an operating lease represents an off-balance sheet asset, since the company is free to use whatever they are leasing to increase profits. At the same time, operating leases represent an off-balance sheet liability, as rather than purchase the asset outright, the company has basically financed it by committing to make payments over a number of years.

In our example, Company A has no operating leases, but Company B has operating leases present valued at $4000. In other words, Company B's return on assets is only 2%, and its debt to equity jumped big-time! But you'd never know it unless you read the notes to the financial statements. (For other gems you can find in the notes, see this page.)

This example was far from an exaggeration by the way. I recently looked at a nursing care provider called Advocat. You wouldn't expect this to be a cyclical company, therefore as we discussed here it can safely carry a higher debt burden. The balance sheet listed debt to invested capital at 70%, but after including operating leases, this number jumped to 96%! Far too high a number for a conservative value investor...